When you tell people that you are studying economics, you may be told that “it’s all about supply and demand”. Whilst that may not be completely true, it is the case for this chapter. In this chapter we will look at supply and demand and how they interact to produce an equilibrium price. We will also address what happens to that price when there is a shift in either demand or supply.
The equilibrium point is the only price where the quantity demanded by buyers is equal to the quantity supplied by suppliers.
The diagram above shows a market that is equilibrium; demand equals supply at the marked equilibrium point. This leads to an equilibrium price of P1 and quantity of Q1.
A price above the equilibrium price will lead to excess supply in the market, this can be shown in the diagram below.
At the price of P1, firms are willing to supply QS, however customers will only demand QD. This leads to excess supply, equal to AB. In this case the price performs the role of sending a signal to producers that the price is too high and it must fall if they are to sell all of their stock. The price also indicates incentives; as the price starts to fall it will demonstrate to suppliers that too many resources have been dedicated to this market and they will reduce their supply.
The effect of a decrease in price on the market is shown below.
The price is lowered from P1 until an equilibrium is reached at a price of Pe and a quantity of Q1. This is known as the market clearing price as all goods have now been cleared from the market. This fall in price causes a movement along the demand and supply curves.
If the price is below the equilibrium price then there will be excess demand in the market, this can be shown in the diagram below.
At the price of P1, firms are only willing to supply QS, however customers will demand QD. This leads to excess demand of AB.
Again the price mechanism will ensure that equilibrium is reached. Signals to producers will indicate that the price and output are too low and they should rise. As prices rise there will be an incentive for businesses to enter the market and start production or for existing businesses to expand production. As prices rise customers will ration the amount they demand.
The effect of an increase in price on the market is shown below.
The price is increases from P1 until an equilibrium is reached at a price of Pe and a quantity of Q1.
Shifts in Demand
We have looked at the factors that could shift the demand curve in an earlier chapter; we now want to see how a shift in demand will impact the equilibrium. Many factors will be affecting a market at the same time.
It would be impossible to try and show all of these changes on a single diagram. We, therefore, have a principle called ceteris paribus; this means that all other thing remain equal. For example, to see how the equilibrium point in the market for Liverpool football tickets is affected only by an increase in income, we would add ceteris paribus to the end of the sentence. This would mean ignoring how well the club is doing in the league, the weather and who the opposition is.
The diagram below shows the effect of demand shifting to the right.
The shift and movement to a new equilibrium can be explained in a number of steps:
- The market is in equilibrium with a price of P1 and quantity of Q1. Demand is equal to supply.
- Demand shifts to the right. This means that customers want to purchase a higher quantity at every price, for example, at a price of P1 demand has increased from Q1 to Q2.
- This will lead to excess demand as customers want to buy Q3, but firms are still only willing to supply Q1. Excess demand is equal to AB.
- The market mechanism sends signals to increase the price. As this price rises there will be an incentive for firms to increase the amount they are willing to sell. The rising prices will also ration the quantity demanded by customers.
- The price will keep on rising until demand equals supply.
- A new equilibrium is reached at a price of P2 and quantity of Q3.
The overall impact is an increase in both the price and quantity. Any increase in the equilibrium quantity means that additional resources have been put into that market. This may lead to an increase in demand in the relevant factor markets (see derived demand below)
Shifts in Supply
We looked at the factors that could shift supply in the last section. A shift in supply to the right will lead to a fall in the price level and an increase in the equilibrium quantity.
Shifts in Demand or Supply
When both demand and supply shift there is no way of knowing what will happen to the equilibrium quantity and price as it will depend upon the relative size of the shifts.
The market is anyplace where sellers and buyers are able to be brought together. It is called a market because many years a traditional market was one of the only places that buyers and sellers could be brought together. Today buying and sellers can be brought together in a wide variety of ways, either in person or virtually via the internet. It is possible to divide markets into local, national and international markets.
The market will attempt to set a price that is acceptable to both the buyer and seller. How the price is fixed can depend on the market and the nature of the buyer and seller.
It is also possible to distinguish between factor markets, where factors of production are bought and sold, and goods markets, where goods and services are traded.